Why Opec's back in business

News Analysis: This time oil price rises may stick, spelling near- term economic danger

THE ORGANISATION of Petroleum Exporting Countries (Opec), which meets in Vienna today, is back in business as a key influence on world oil production.

After several years during which Opec's ability to influence oil prices has waned, there are high hopes that it will be able to strike a deal to curb production and provide a much-needed boost to the oil industry.

Oil prices have already soared to a five-month high amid market hopes of effective Opec action. Two weeks ago, at a pre-summit meeting in the Netherlands, key Opec members hammered out a series of proposals for production cuts.

Talk of production cuts was, in itself, nothing new. Just last year, for example, Opec agreed a range of supply reductions, but widespread cheating on quotas meant there was no substantial impact on prices.

This time round, though, the market seems to be convinced that Opec - which is expected to ratify its pre-summit proposals in Vienna today - can make the new quotas stick. As a result, oil prices are running almost 40 per cent higher than they were during the autumn's 12-year lows.

Analysts have identified several factors that should help to support the oil price in the short term. First, there are political considerations. Part of the reason why supply cutbacks failed to materialise last year was a long-running rivalry between Saudi Arabia and Iran.

Last year, Iran was not actively involved in negotiating the quotas, and objected vehemently to the cuts proposed by rival Opec nations. In recent weeks there has been an attempt at reconciliation by Saudi Arabia and Iran, Opec's two largest producers, with Saudi's Prince Abdullah doing much of the running.

The two nations have been spearheading this latest attempt to cap oil supply. "Saudi Arabia and Iran seemed to have patched up their difficulties," said Stephen Lewis, chief economist at Monument Derivatives. "The shift in the Saudi position is a new element in the situation."

Second, it has historically been easier for Opec to implement production cuts when oil prices are rising, as they are at the moment, than when they are falling, as they were for most of last year. As Mr Lewis said: "If Opec governments are able to recoup through higher prices the potential losses in revenues stemming from production cuts, they can afford to be more relaxed about the situation than when both output and prices are declining."

Third, the economic havoc wreaked by the recent low oil prices in Opec countries - many of which are almost wholly dependent on oil revenues - has toughened the political will to make the new quotas work.

Senior officials from all the Opec nations have been talking tough in recent days. There has been a realisation throughout the region that if Opec doesn't act, the economic misery will only get worse.

In the short term, therefore, the market seems convinced that oil will hold on to its recent price gains. However, in the longer term sentiment is far more bearish. Few experts believe the oil price will continue to chalk up sizeable gains.

Fewer still think Opec will achieve its stated aim of pushing the price of West Texas Intermediate, currently running at around $15 a barrel, back to the $18 to $20 range. Fundamentals are weak - world oil demand is expected to grow by only 1 per cent this year, while stock overhangs in oil-producing countries remain high. The incentives to cheat on the quotas will increase as the oil price rises. And Opec is far less powerful than it was during the 1970s, when it had a virtual stranglehold over oil supply. It now controls less than one-third of world production.

Rachel Beaver, analyst at ABN Amro, said: "Last week's surge in oil prices clearly owed more to sentiment than to fundamentals, which indicate demand remaining sluggish, stocks high and spare upstream capacity."

Even if the oil price falls short of Opec's optimistic expectations, its recent mini-recovery has important implications for the world economy. For the world's oil producers, it's great news. London benchmark Brent crude now stands at around $13.50 a barrel, well off last year's low of less than $10.

Industry rule-of-thumb is that it is difficult for most producers to make any money at all when London Brent falls below $12 a barrel. Not surprisingly, then, the recent turn of events has put a smile back on the faces of oil barons the world over.

For the rest of the economy, however, this rise in the oil price could spell danger. Michael Saunders, at Salomon Smith Barney/Citibank, has calculated that if Brent prices rise to $15 a barrel, inflation in the euro area could be boosted by up to half a percentage point this year and as much as 1.5 points next year as the rise in production costs feeds through to consumer prices.

A rise in inflation presents risks to growth, and there are fears in the markets that a resurgence in commodity inflation could prompt the world's monetary authorities to put up interest rates. Those countries with no oil reserves of their own - such as Japan - have the most to lose. Already the yen has weakened substantially against the dollar amid fears that an oil price rise could damage any economic recovery in the region.

Of course, this all needs to be kept in proportion - the power that Opec wields over the world economy is far less than during its heyday of two decades ago. But recent events have shown that it would be premature to write off the organisation altogether.